Toiling as a research analyst for an investment bank isn't what it used to be. Treated like rock stars during the stock market "bubble" years, research analysts have become an easy and frequent target for criticism from all quarters. By now you have heard allegations from the New York State Attorney General, the Securities and Exchange Commission and U.S. legislators that a lack of independent research duped many individual investors into collectively losing billions of dollars during the most recent bear market.

Serious reform efforts have accompanied the criticism, some beginning in early 2001. The National Association of Securities Dealers Board of Governors, for instance, recommended for the first time in July 2001 that research reports include disclosure on conflicts of interest. The New York Stock Exchange implemented new rules governing research analysts in July 2002 after its board of directors approved sweeping changes in February 2002. More recently, Eliot Spitzer, the New York State Attorney General, has taken several high-profile actions to force investment banks to clearly separate research from the rest of the institution. In addition, investment banks have responded by making their own proposals for restructuring research.

This issue is not a narrow, esoteric governance debate. It is one piece of the country's current attention to corporate governance in general, spurred in part by the downfall of corporate giants such as Enron, Global Crossing and WorldCom. To some extent, sheer numbers explain why it has captured the average American's attention.

The individual investor plays a prominent role in the U.S. equity markets, both through mutual fund holdings and direct equity investments. Based on a recently issued report by the Securities Industry Association, the total value of individual stocks held directly by retail investors is approximately $3.7 trillion, down from a total value of approximately $4.1 trillion in 1999. Despite the decline, individual stockholders remain a significant force in the U.S. equity markets, and they have seen hundreds of billions of dollars of wealth evaporate in the last several years. It is little wonder that the analyst-independence issue has gained such traction among a wide swath of the U.S. investing public.

Critics say that while investors seek unbiased, independent coverage of companies to assist in investment decisions, analysts instead may issue research reflecting a positive bias due to personal or structural conflicts. A research analyst who receives a significant portion of his or her compensation in a bonus tied to investment-banking revenues may have a meaningful economic incentive to look on the bright side when judging a company's prospects. Critics claim to have data supporting this assertion, not the least of which is the preponderance of "strong-buy" recommendations as reported by Thompson First Call.

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Have analysts been as positive about companies that ultimately file for bankruptcy as they have been about successful companies?

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Naturally, we are interested in the analyst independence issue from a bankruptcy angle. Have analysts been as positive about companies that ultimately file for bankruptcy as they have been about successful companies? Perhaps more importantly, has there been any tempering of analyst optimism given the reform efforts and exposure concerning research independence?

We try to answer these two questions by taking a look at the data from a bankruptcy perspective. First, we assembled a group of bankruptcies involving public companies with at least $500 million of assets during the 1999 to mid-2002 period. Our search criteria led to a sample size of 55 companies ranging from ANC Rental Corp. to Metromedia Fiber Network to Williams Communications Group. Next, we surveyed Thompson First Call for all research analyst reports on these 55 companies, tracking analyst recommendations during a two-year period leading up to bankruptcy.

We then converted each research analyst's rating system to a numerical scale and calculated averages. Prior to conducting the analysis, we generally expected our sample companies to be rated between a "buy" and a "strong buy" at two years prior to a bankruptcy filing declining to something approaching a "sell" at some point prior to bankruptcy.

Analysis results show that research has been very optimistic even in the case of future bankruptcies. The adjacent chart shows the average rating for our sample. Two years prior to bankruptcy, the average analyst rating is slightly above a "buy" recommendation. The average rating declines slightly over the next 18 months, but even at six months prior to failure, research analysts maintain an average rating well above "neutral." For the smaller sample that enjoy analyst coverage up to bankruptcy, the average rating declines to a negative bias below "neutral," but remains above "underperform." Even in the weeks and days leading up to a chapter 11 filing, research analysts have not reduced a failing company's rating to a "sell," as shown in Chart 1.

The data also points out that a large number of analysts simply stop writing on companies prior to bankruptcy. There were 159 analyst ratings of our sample companies at six months prior to a chapter 11 filing. The number of ratings fell to 90 in the period immediately preceding bankruptcy, and only 15 analysts actually chose to inform the market that they had discontinued coverage. The remainder appeared to stop publishing without public notification.

As stated above, critics say that analysts are beholden to investment banking clients and the future fees they may bring. This theory has been evident in e-mails disclosed by Spitzer in his inquiries. Yet in instances where management and accounting fraud is involved, it could very well be that research analysts are just as shocked as the average individual investor upon its disclosure. The same might be true of businesses subject to sudden liquidity challenges such as losing access to the commercial paper market. The point is that it is not reasonable to expect research analysts to anticipate failure in every instance. On the other hand, most bankruptcies arise from fundamental and honest missteps that should be apparent to those that monitor companies as closely as research analysts are supposed to do.

There are emerging signs that all of the attention, regulatory and otherwise, is bringing about the desired result—greater research analyst freedom to rate companies without worrying about investment banking relationships. Chart 2 shows the average rating for companies filing bankruptcy in 1999, 2000, 2001 and the first part of 2002. The various dashed lines display the average rating of companies that filed for bankruptcy in 1999-2001 respectively, while the solid line shows the same statistic for companies that have filed in 2002. Note that the more recent bankruptcies have carried lower average analyst ratings than those that filed in 1999-2001 during most of the two-year period leading up to failure. Certainly one explanation for the lower ratings for more recent bankruptcies could be the reform efforts and public backlash discussed above.

Admittedly, the 2002 bankruptcies are a small sample, and the reforms and rhetoric have only existed for a short period. Nonetheless, given the negative economic incentives associated with retaining the old research model, we are inclined to believe that this trend will continue.

It is a great American tradition to identify victims in a situation such as this. Institutional investors (including managers of 401(k)s and pension funds) typically maintain their own research capability and supposedly knew that a "buy" rather than a "strong buy" used to be a signal to sell. On the other hand, a research report in the hands of an experienced retail broker can be a very convincing sales tool, particularly if the individual investor has abdicated responsibility because of a lack of knowledge, experience or time.

While the retail investor has been labeled as the primary victim of overly optimistic research, it is their responsibility to read what gets published rather than rely solely on a broker's recommendation. One recent study conducted by two finance professors at Boston University provided an in-depth look at research reports published on future bankrupt companies and concluded that the text of the reports often contradicted the analyst rating on the cover. One can only speculate that the retail investor or broker never bothered to make it past the cover to read the more detailed analysis that could have changed an investment decision. This is not to say that research analysts are above the charges of irresponsible ebullience, but this is not the one-dimensional problem that some in the press might make it.

The point is that there is plenty of blame for everyone to share. With the exception of your next door neighbor who announces proudly that she sold all of her investments in March 2000, no one who participates in the equity markets is absolved of at least a little responsibility. That's what makes a bubble a bubble.